EUROPE´S FUTURE DIFFERS FROM JAPAN´S PAST / THE FINANCIAL TIMES MARKETS INSIGHT ( VERY HIGHLY RECOMMENDED READING )

Europe’s future differs from Japan’s past

By Stephen Macklow-Smith

Published: September 6 2010 18:36

Europe today has many obvious similarities with Japan 20 years ago. In 1990, after a decade of rising asset prices, Japan saw a demographic shift, with retirees growing and the workforce pretty much static. In Europe a similar thing is happening in many countries, most notably in Germany, Italy and Spain.

By 1990 Japanese real estate prices had also become overvalued, and the subsequent falls in real estate and land prices caused non-performing loans to rise, leading to problems in the banking sector. There are echoes today of a similar problem in Europe, particularly in markets such as Ireland and Spain.

As in Europe today, the Japanese equity market fell sharply and rates of gross domestic product growth declined, as did long-term interest rates. Eventually the Japanese economy became mired in a deflationary mindset, which quantitative easing was not able to counteract. All this took place against a background in which most key decisions were taken behind closed doors at the Bank of Japan and the Ministry of Finance.

The question is whether Europe is heading into the deflationary mire as Japan has found itself? It is striking to many commentators that, just as in Japan, the key discussions in the eurozone have all been taking place behind closed doors in Brussels and Frankfurt, and the European Central Bank is famously reticent about making its deliberations public.

There are, however, crucial differences between Japan and Europe. First, early in the 1990s (now commonly referred to as Japan’s lost decade) the yen continued to strengthen, by about 60 per cent on a trade-weighted basis, remaining a strong currency thereafter.

Contrast this with what has happened to the trade-weighted euro exchange rate since the global financial crisis broke in 2008. Rather than strengthening, the euro has weakened substantially. The beneficial impact for European exporters has been considerable, helping hold up industrial output.

A second key difference is that in the early stages of the Japanese crisis the Bank of Japan continued to tighten monetary policy. In Europe, monetary policy has been aggressively eased in the past two years, and in spite of statements from Jean-Claude Trichet, ECB president, of the need to tighten, eurozone monetary conditions are now the loosest in the world.

Japan did eventually cut rates, and then moved to quantitative easing in the early 2000s, but this policy reversal came many years into the crisis and, crucially, after deflation had taken hold. In Europe, by contrast, the ECB has expanded its balance sheet hugely in order to provide the necessary liquidity to the economy.

The third difference is in the property market, where overvaluation in Japan reached levels far in excess of what we have seen in Europe. The figures are difficult to access on a comparable basis, but Citigroup have provided us with two revealing series comparing home prices with income. For all the excesses of the Spanish real estate boom, house prices peaked at about eight times gross annual income, whereas in Japan the peak was closer to 18 times. Land prices in Japan were so elevated in 1990 that at one point it was believed that the Emperor’s Palace in Tokyo was worth more than California.

The final key difference is in equity prices. In the 1990s Japanese equities were as demandingly priced as Japanese houses. Japanese price/earnings ratios rose sharply, reaching a peak of more than 80 times by 1999. Compare this to Europe, where the p/e on the MSCI Europe index has fallen over the past decade and currently stands at less than 15 times historic earnings.

European equities have always been significantly cheaper than Japan, and remain cheaper now, in spite of the Japanese market trading sideways for two decades. Citigroup recently published a note looking at earnings in the Japanese stock market over this period. It found that nominal GDP (a key driver of earnings) has risen by only 13 per cent over the whole of the past 20 years in Japan. Within Japan’s GDP, the corporate profit share has fallen, putting pressure on corporate earnings. At the same time, a great deal of equity capital has been raised, and, since returns on equity have been depressed, this has resulted in significant earnings dilution.

There is one further factor to throw into the mix. One European country back in 1990 faced many of the same problems as Japan: highly valued real estate, a strengthening currency, years of poor GDP growth, very low long-term interest rates, and a somewhat secretive approach to policy. That was Switzerland.

Yet it only takes a glance at the difference in equity returns between Switzerland and Japan over the past 20 years to see how much better Switzerland has fared at tackling these problems. It is always tempting for investors to look for parallels with the past, but they don’t tell the whole story.

Stephen Macklow-Smith is managing director and senior portfolio manager at JPMorgan Asset Management

Copyright The Financial Times Limited 2010